Commercial real estate investment offers steady income and potential long-term growth. Understanding a property’s rental yield, or income, can give you valuable insights into a property's return on investment.
Rental yield helps assess the financial viability of a property. This, in turn, helps you to gauge the attractiveness of a specific deal and/or compare investment opportunities.
In this guide, you’ll learn what factors to take into consideration when identifying a good rental yield.
What is Rental Yield?
Rental yield is a financial indicator that measures the return on investment from a rental property. Rental yield is calculated as a percentage on an annual basis.
This indicator helps investors assess the profitability of a property in terms of rental income. Distinguishing between gross yield and net yield is critical to understand the different aspects of the property's return.
Gross yield is the annual rental income divided by the property's total value, multiplied by 100. This gives an overview of the property's potential return.
This calculation excludes the expenses and costs associated with owning a property.
Net yield, on the other hand, takes the property's operating expenses into account. These expenses are things like maintenance costs, property taxes, and insurance. Net yield gives you a more realistic picture of the actual return on your investment.
How to Calculate Gross Rental Yield
These are the steps to calculate the gross rental yield:
- Work out the total annual rental income generated by the property
- Divide the annual rental income by the property's total value
- Multiply the result by 100 to get the gross rental yield percentage
Gross Rental Yield = (Annual Rental Income / Property Purchase Price) × 100
You buy a rental property for $200,000. It generates an annual rental income of $20,000. The gross rental yield would be:
Gross Rental Yield = ($20,000 / $200,000) × 100
How to Calculate Net Rental Yield
To calculate the net rental yield, do the following:
- Calculate the total annual rental income from the property
- Deduct all operating expenses, such as:
- property management fees
- maintenance costs
- property taxes
- Subtract the total expenses from the annual rental income
- Divide the result by the property's purchase price and multiply by 100 to get the answer as a percentage
Let's assume the property brings in an annual rental income of $30,000. The operating expenses amount to $4,000 and the total value of the property is $550,000.
The calculation would be as follows:
Net Rental Income = Annual Rental Income - Operating Expenses
= $30,000 - $4,000
Net Rental Yield = (Net Rental Income / Property Purchase Price) x 100
= ($26,000 / $550,000) x 100
Factors that Influence Rental Yield
The rental yield of a property is influenced by several factors, such as:
The location has a significant impact on rental demand and rates. Properties in prime, high-demand areas call for higher rental prices.
Property Type and Quality
Tenants are willing to pay higher rents for well-maintained properties. High-paying tenants are often drawn to desirable amenities and features.
Real Estate Market Conditions
High-demand markets and low vacancy rates result in higher rental income. Oversupply or economic downturns may lead to lower rental income.
Property Management Costs
Fees for professional management services, for instance, also have an impact on the net rental income. It is essential to consider these costs when calculating potential returns from a rental property.
Understanding 'Good' Rental Yield
The concept of a ‘good’ rental yield or profit is subjective and depends on various factors. Generally, you want a higher rental yield because it indicates a greater return on investment.
However, what makes a good rental yield varies across markets and investment strategies.
Several factors can influence what is considered a good rental profit:
The State of the Local Market
Rental yields can vary significantly based on the local real estate market.
Investors should research and compare rental yields in the specific market where they intend to invest.
This will help them to gain a better understanding of the current prices and the level of rents that can be charged, hence impacting the rental yield.
Investment Objectives and Methods
Your rental income expectations should correspond with your investment goals and strategies. Some investors focus on steady cash flow and income stability.
Conversely, an investor looking for long-term capital growth might accept a lower rental income in exchange for the property's growth potential. The ideal rental yield will depend on your goals.
Higher rental earnings may come with higher risks. These include possible vacancies, difficult tenants, or fluctuating market conditions. Before investing, you should consider your risk tolerance and the potential risks of a greater rental income.
How to Improve Rental Yield
Various external factors can influence rental yield. The good news is that there are strategies to boost rental profit.
We have rounded up the top four strategies:
1. Choose Properties with Care
Choose properties in locations with high rental demand and potential for growth. Investigate market trends, employment opportunities, and local amenities. This will ensure the property attracts quality tenants.
2. Conduct Thorough Market Research to Establish Competitive Rental Prices
Setting reasonable yet profitable rental rates will help increase your rental income. It will also help to keep tenants satisfied.
3. Keep the Property in Good Condition.
Regular maintenance and periodic upgrades enhance a property's appeal. It also justifies higher rent and attracts quality tenants.
4. Efficient Property Management
Good property management can cut expenses and vacancies. For maximum rental profit, use reliable property management services. You could even try efficient self-management practices to save on costs.
Pitfalls of Focusing Solely on Rental Yield
Although rental yield is an important metric, focusing only on high rental yields can have drawbacks. It is important that you consider other factors as well, such as:
- Property value appreciation
- Local real estate market conditions
- Potential long-term growth
Some risks associated with chasing high rental yields include:
Property Quality and Demand
Properties with exceptionally high rental yields may be located in undesirable areas or need a lot of maintenance.
This can result in attracting lower quality tenants or even struggling to find tenants at all. In return, this could negatively impact long-term profitability.
Limited Market Growth
High rental income in a specific market may indicate a stagnant or declining market.
Consider the possibility of increased property value and market expansion. This will help to establish a sustainable investment.
Inflation and interest rates, for example, can have an impact on rental income. Changes in these factors can impact rental demand and the ability to maintain high rental yields.
Comparison of Rental Yields Across Different CRE Markets
Comparing rental yields across different CRE markets can offer useful insights.
Analyzing the average yields in different CRE sectors can help to identify potential opportunities and highlight areas of caution.
Rental yields in cities may be higher than in suburbs or rural areas.
Retail properties in prime shopping districts or high-traffic areas may offer better yields. This is due to increased foot traffic and consumer spending.
Investors should conduct thorough research and consult professionals with market-specific expertise. Past and present rental yield trends and current market conditions can help you identify market segments with potentially higher yields. You can then adjust your investment plans as needed.
Final Thoughts on Rental Yield
When investing in commercial real estate, it’s important to consider rental yield. It provides useful information about a property's prospective profitability and is therefore critical for making informed investment decisions.
However, rental earnings should not be the only thing you consider when evaluating a property's suitability.
You should also consider factors like property value appreciation and market circumstances. Investment goals and strategies also play an important part in the decision-making process.
A holistic approach that takes multiple factors into account is most effective and will allow you to make sound judgments that are in line with your financial goals.